What is a financial model?

A financial model is a tool that’s built in Excel to forecast a business’ financial performance
into the future. The forecast is typically based on the company’s historical performance and
requires preparing the income statement, balance sheet, cash flow statement and supporting
schedules.

What is a financial model used for?

The output of a financial model is used for decision-making and performing financial
analysis, whether inside or outside of the company.
Inside a company, executives will use financial models to make decisions about:
• Raising capital (debt and/or equity)
• Making acquisitions (businesses and/or assets)
• Growing the business (i.e. opening new stores, entering new markets, etc.)
• Selling or divesting assets and business units
• Budgeting and forecasting (planning for the years ahead)
• Capital allocation (priority of which projects to invest in)
• Valuing a business

Who builds financial models?

There are many different types of professionals who build financial models. The most
common types of career tracks are investment banking, equity research, corporate
development, FP&A, and accounting (due diligence, transaction advisory, valuations, etc.).

How do you build a financial model? (10-step Guide)

Financial modeling is an iterative process. You have to chip away at different sections until
you’re finally able to tie them all together.
Below is a step-by-step breakdown of where you should start and how to eventually connect
all the dots.
1. Historical results and assumptions
Every financial model starts with a company’s historical results. You begin building the
financial model by pulling three years of financial statements and inputting them into Excel.
Next, you reverse engineer the assumptions for the historical period by calculating items such
as revenue growth rate, gross margins, variable costs, fixed costs, AR days, inventory days,
and AP days, to name a few. From there you can fill in the assumptions for the forecast
period as hard-codes.
2. Start the income statement
With the forecast assumptions in place, you can calculate the top of the income statement
with revenue, COGS, gross profit, and operating expenses down to EBITDA. You will have
to wait to calculate depreciation, amortization, interest, and taxes.
3. Start the balance sheet
With the top of the income statement in place, you can start to fill in the balance sheet. Begin
by calculating accounts receivable and inventory, which are both functions of revenue and
COGS, as well as the AR days and inventory days assumptions. Next, fill in accounts payable
which is a function of COGS and AP days.

4. Build the supporting schedules

Before completing the income statement and the balance sheet, you have to create a schedule
for capital assets like PP&E, as well as for debt and interest. The PP&E schedule will pull
from the historical period and add capital expenditures and subtract depreciation. As for the
debt schedule, it will also pull from the historical period and add increases in debt and
subtract repayments. Interest will be based on the average debt balance.

5. Complete the income statement and balance sheet

The information from the supporting schedules completes the income statement and balance
sheet. On the income statement, link depreciation to the PP&E schedule and interest to the
debt schedule. From there you can calculate earnings before tax, taxes and net income. On the
balance sheet, link the closing PP&E balance and closing debt balance from the schedules.
Shareholder’s equity can be completed by pulling forward last year’s closing balance, adding
net income and capital raised and subtracting dividends or shares repurchased.

6. Build the cash flow statement

With the income statement and balance sheet complete, you can build the cash flow statement
with the reconciliation method. Start with net income, add back depreciation and adjust for
changes in non-cash working capital, which results in cash from operations. Cash used in
investing is a function of capital expenditures in the PP&E schedule, and cash from financing
is a function of the assumptions that were laid out about raising debt and equity.
7. Perform the DCF analysis
When the three statement model is completed, it’s time to calculate free cash flow and
perform the business valuation. The free cash flow of the business is discounted back to today
at the firm’s cost of capital (its opportunity cost, or required rate of return). We offer a full
suite of courses that teach all of the above steps with examples, templates, and step-by-step
instruction. Read more about how to build a DCF model.
8. Add sensitivity analysis and scenarios
Once the DCF analysis and valuation sections are complete, it’s time to incorporate
sensitivity analysis and scenarios into the model. The point of this analysis is to determine
how much the value of the company (or some other metric) will be impacted by changes in
underlying assumptions. This is very useful for assessing the risk of an investment or for
business planning purposes (i.e. does the company need to raise money if sales volume drops
by x percent?).
9. Build charts and graphs
Clear communication of results is something that really separates good from great financial
analysts. The most effective way to show the results of a financial model is through charts
and graphs, which we cover in detail in our advanced Excel course as well as many of the
individual financial modeling courses. Most executives don’t have the time or patience to
look at the inner workings of the model, so charts are much more effective.

Why build a financial model?

For anyone pursuing or advancing a career in corporate development, investment banking,
financial planning and analysis (FP&A), equity research, commercial banking, or other areas
of corporate finance, building financial models is part of the daily routine. Financial models
are essential tools to help make decisions. These decisions often include: whether or not to
invest in a company, asset, or security; whether or not to invest in a project (project finance);
whether or not to do a merger or acquisition; whether or not to raise money, as well as other
corporate finance transactions Financial models allow decision-makers to test scenarios,
observe potential outcomes, and make informed decisions. There is a lot of talk about
software programs that can be used, but the truth is the vast majority of financial modeling
takes place in Excel.

Excel tips and tricks

As mentioned earlier, Excel is the main tool used by banks, corporations, and institutions to
perform financial modeling. The main reason for this is Excel’s remarkable versatility. Every
company or investment opportunity is unique, and Excel is a blank canvas that can be totally
customized and tailored to any financial situation. The flip side of this is that there are no
controls or rules in place to ensure the model is accurate or error-free.
Here are some of the most important Excel tips for financial modeling:
1. Use as many keyboard short-cuts as possible.
2. Keep formulas and calculations simple – break them down into smaller steps.
3. Use the grouping function to organize sections of the financial model.
4. Use F5 (go to special) to quickly locate all hardcoded numbers or formulas.
5. Use Trace Precedents and Trace Dependents to audit the model.
6. Use XNPV and XIRR to apply specific dates to cash flows.
7. Use INDEX MATCH over VLOOKUP for looking up information.
8. Use a combination of date functions (EOMONTH) and IF statements to make dates
dynamic.
9. Remove grid lines when presenting or sharing the financial model.
10. Memorize the most important Excel formulas for financial modeling.

Modeling best practices

Over and above good Excel skills, analysts who really stand out in financial modeling are
great at structuring and organizing their spreadsheets.
Here are our top 10 best practices for structuring a model:
1. Use color-coding to distinguish between inputs and formulas (i.e. blue and black).
2. Build a standalone 3 statement model on one worksheet (don’t separate the statements onto
different sheets).
3. Clearly separate the assumptions or drivers from the rest of the model (one section at the
top).
4. Use clear headers and subheads (with bold shading) to clearly distinguish sections.
5. Use the cell comments function (shift + F2) to describe calculations or assumptions that
need explaining.
6. Build in error checks such as ensuring the balance sheet balances (without a plug).
7. Pull forward (or repeat) information where it helps users follow the logic of the model (i.e.
pull forward EBITDA from the income statement to the cash flow valuation section).
8. Avoid linking to other Excel workbooks unless absolutely necessary (and if so, clearly
indicate those links exist).
9. Avoid circular references unless necessary (and use iterative calculation to solve them).
10. Use tables, charts and graphs to summarize important information.

Overview of financial modeling skills

This guide will focus on the most important financial modeling skills required to be a world-
class financial analyst.
These are:
1. A solid understanding of accounting
2. Strong Excel skills
3. Knowing how to link the 3 financial statements
4. Understanding how to build a forecast
5. A logical framework for problem solving
6. Attention to detail
7. Ability to distill large amounts of data into a simple format
8. An eye for design and esthetics
Each of these financial modelling skills will be broken down in further detail below. As the
image below shows, these skills can be divided into 3 categories: accounting/finance, Excel,
and problem solving/logic/design.